Saturday, December 10, 2016

Managing Risk vs Reward

The SP500 tagged its first upside objective on Friday as the surge since the election continues. I don't like calling this a "Trump Rally", many of these groups had been strong all year prior to the election and the resolution of the event simply caused many out-of-position investors to reallocate.

Its not a Trump rally, its a FOMO rally as the economy is not nearly as bad as many suggested it was. As usual investors let fear lead their investment process and are now scrambling to adjust as they have done over and over throughout history.

We on the other hand like to think independently of the emotional fear and greed slaves. We prefer to find where money is flowing, where value may be lurking, and where risk/rewards may be out of favor. Its our job as systematic traders/investors to not concern ourselves with politics, media hype, or the like. We are hear to find key turning points for new and old trends.This doesn't mean we pick tops or bottoms, what we want to find are new base setups to position into before the media and emotional traders figure out what is happening.

At a glance it appears the rotations continue to flow into Tech and Energy after multiple weeks of consolidation. Just because these groups didn't react as strongly as others to the initial wave up in the market doesn't mean they should be ignored. Quite the opposite really, now that the first wave of leaders are well extended from their bases I want to see where the next leg of the rally will be coming from. I am not bearish on Banks and Industrials, but I am not a buyer at current levels either as the pattern in place we have already positioned into when they first emerged from their bases (note I am quite bullish on Banks and Transports long-term). For new funds I am liking what I see in Large Cap Tech especially. This appears to be the next area of interest as the breakout is only now getting underway.

XLK
The weekly chart of Technology signaled a new bull flag breakout after trading sideways since July. This is a 17-week secondary base formation that is now resuming to the upside after the initial July surge from the nearly 2-year primary base structure. When we are discussing strong risk/reward this is what we are talking about. It is also the first time the group has closed a week at new all-time highs since the first week of August.

After completely reversing last week's bearish outside range, XLK regained new highs and the rising 20 SMA. That's very bullish behavior. In contrast to this orderly consolidation take a look at Industrials and Financials currently over the same timeframe:

XLI

XLF
Most news has been suggestive of caution toward Technology and growth stocks recently, and with reason as they haven't traded strongly in the past month. While many deem that as "worrisome" behavior for the market in general, I simply see it as a prior leadership group that took a rest and is now ready to resume what it was doing in July.

Different groups come in and out of favor all the time. The steady flow of funds from relative expensiveness to relative value and back again is very normal. When you trade these longer term charts, sitting through periods of digestion is often necessary to catch the biggest moves. Looking at the XLF above my trend method had two strong risk/reward entry points prior to the large surge; the last week of July was the first major trend change, then again at the close of September was another.

As most know it was difficult to get involved once the November breakout was already underway. The consensus narrative was that the move was just a "knee-jerk" or "too far too fast". But had one been willing to sit through several weeks of orderly consolidation and followed the initial signals (while everyone was obsessing about the election and when the next market crash was coming), there were tremendous rewards gained for trading the price and pattern rather than the news flow.

For the past couple months Tech stocks have mostly churned, it now appears they are likely to step into the next leadership position.

AAPL

MSFT

NFLX

GOOGL

BABA

Stocks go both up AND down. I know it seems when stocks are rallying they will never give us a good entry again and when they are correcting they will never turn things around. Its important to remember that the consolidation is necessary to set up the next rally opportunity. The swing point tells us where the real buyers are and allows us a better reward to risk for our money. The key is to not get caught up in the narrative and execute the signals when they first present themselves. Most are afraid to buy the early base signal still fearing the negative news flow, by the time the real move has been made only then do they have the confidence that its finally safe to enter. This behavior leads to chasing and getting shaken out repeatedly, or buying high and selling low.

We strive to not be emotional traders, have a systematic process based on the price action, and follow the signals the system triggers regardless of the current narrative of the financial media. Making these small adjustments in the overall process helps improve our long-term expectancy and profitability.

Thanks for reading
ZT

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